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Testing for the Diffusion Matrix in a Continuous-Time Markov Process Model with Applications to the Term Structure of Interest Rates

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  • Fuchun Li

Abstract

The author proposes a test for the parametric specification of each component in the diffusion matrix of a d-dimensional diffusion process. Overall, d (d-1)/2 test statistics are constructed for the off-diagonal components, while d test statistics are constructed for the main diagonal components. Using theories of degenerate U-statistics, each of these test statistics is shown to follow an asymptotic standard normal distribution under null hypothesis, while diverging to infinity if the component is misspecified over a significant range. Our tests strongly reject the specification of diffusion functions in a variety of popular univariate interest rate models for daily 7-day eurodollar spot rates, and the specification of the diffusion matrix in some popular multivariate affine term-structure models for monthly U.S. Treasury yields.

Suggested Citation

  • Fuchun Li, 2015. "Testing for the Diffusion Matrix in a Continuous-Time Markov Process Model with Applications to the Term Structure of Interest Rates," Staff Working Papers 15-17, Bank of Canada.
    • Handle: RePEc:bca:bocawp:15-17
    as

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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Asset Pricing; Econometric and statistical methods; Interest rates;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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